Project Cash Flow

Net cash flow is the key to all investment decisions. This number enables the conversion of all elements of the project to their effec­tive cost, from which the different projects relative necesaity and usefulness can be realistically compared.

Net cash flow (NCF) is used:

1. To measure the return of the project and liquidity over the work of the project

2. To calculate economic return by the net present value NPV

3. To calculate the risk assessment of the project

4. To reduce taxes on the life of the project

Net cash flow each year is calculated as the revenue from the project after subtracting the expense cost every year:

• Net cash flow = revenue -(operating cost + additional indirect expenses + taxes + investment + depreciation)

Revenue is the owner’s income from the project every year. It is calculated as a function of the volume of production that the project produces multiplied by the price for this product.

Operating cost consists of the direct cost, the cost of the materials used in the product, and the indirect cost, the salary for the man­agement level, computers, furniture, and others.

Taxes, the most time-consuming subtask in the working-up of net cash flow (NCF) estimates, are a critical element of project management. There are production taxes, sales taxes, property taxes, state or regional income taxes, and corporate income taxes to be taken into account, among others. The applicability and amount of various taxes are functions of the location of the project and the laws govern such projects in whatever the country.

There is more than one way to compare different projects. A good rule of thumb is that any investment project should be profit-based. Therefore, the owner is normally involved in the feasibility study phase, making a comparison between more than one project in order to determine the revenue that suits the required interest rate that it deems appropriate to the company goal. Different economic calculation methods that assist decision-making are illustrated in this chapter.

Making a comparison is very important in feasibility studies for any project. It is important that in any of these methods you should identify the net cash flow.

Figure (3.1) shows the net cash flow diagram. For the beginning of the project, a lot of money will be spent to build the infrastructure or to purchase machines and other necessary equipment required to deliver the required product. The value of these assets is called a capital cost (CAPEX), and most of this expenditure arises at the project’s outset.

Assume that a project will start after one year. In this year, you sold your product. Hence, knowing the price and the number of products you will sell will enable you to define the revenue in the first year and to carry the calculation-estimate forward, into the second year, third year, and for the lifetime of the project.

Net cash flow “NCF”




1 Revenue


1 l 1 1 I

, Taxes

1 1 1 1 ]

, Others

R=Revenue Opex=Operating cost Capex=Capital cost Taxe=Taxes & royalities pays

Figure 3.1 Net cash flow diagram.

The number of products for every year can be known, but with uncertainty. Also, when you seek to establish the price of the prod­uct, this number may not be so simple to obtain: it varies from year to year, and further uncertainty about this number must increase with time. Determining the value of a price requires a specialized consultant for types of project investments such as building hotels, which is different than a factory for producing children’s games, or a steel-making centre. Therefore, a strong market research study is needed that identifies the competition, works out the market demo­graphics, and uncovers global market trends that would assist developing an export strategy for the product.

In the oil and gas business, there are specialist teams in the main office of each international company that provide advice about each country. Any country that has this development also has a team to perform this calculation, as the revenue in this case will be the volume of barrels of oil that can be produced every day, which depends on the reservoir, where uncertainty lies in predict­ing its volume. However, the oil price will be set by the company’s headquarters as it develops a strategic plan for future prices.

Подпись: Barrel oil per day

For example, a reservoir for oil and gas can be predicted, but it is constrained by operational capabilities, which include managing the reserve to maintain the pressure inside the reservoir by limiting the production. From Figure (3.2) it is shown that production will

Project Cash Flow

Figure 3.2 Production performance over project life time.

increase in the first few years, and after that it will be stable for a few years, and then it will decline until reaching the uneconomic limit of the well, which should be defined. As this limit, the expenses will be higher than the gain, so the well will be shut off.

As shown in Figure (3.1), the revenue is a positive to the cash flow, but every year there will be an expense due to operation, maintenance for the equipment, and other expenses. The operation and maintenance cost is called the ОРЕХ. In addition to the opera­tion cost, there will be taxes that will be paid to the government, which will usually be a percentage from the production.

Any equipment has a lifetime. From an engineering point of view, the equipment and building lifetime is defined as being usable until it fails or is functionally not usable. But there is also a financial life­time from a financial point of view. All equipment has a value when it is new, but with time its value reduces, and when you need to dispose of it through sale, it will have another price. This price is called the book value. Each year there will be a depreciating cost for this equipment. The value of this depreciation is governed by a schedule used by the tax authority of the host government.

Assume you purchase a new car that costs $20,000 now. The next year you want to sell it, and according to the market its value is $15,000. Therefore, you assume that the value of your asset reduces from $20,000 to $15,000. But what about after 4 years? Assume the book value drops to $12,000 in the fourth year after you purchased the car, but in the market it will cost $10,000. In a private company this is not a problem, as you will simply lose money on the sale. But for a government or public company, this will be a problem, especially in developing countries where relatively stringent rules may compel sale of the car at a price based on the book value or higher.

The depreciating value of any equipment will be deducted from the corporation’s taxes. The rate of depreciation can be calculated by different methods, but all of these methods are used based on the government’s tax laws. The most common depreciation method will be illustrated.